Corporate Finance Making the break. A practical guide to MBOs Audit.Tax.Consulting.Corporate Finance. This guide is designed to help managers who are considering a management buy-out (MBO). It sets out some of the critical decisions which have to be made, addresses some frequently encountered issues, describes the various stages of the acquisition and explains how we can help manage the process. Contents 1. Introduction 1 2. What is a management buy-out? 3 3. Criteria for a successful buy-out 6 4. An appropriate funding structure 9 5. The buy-out process 14 6. Some common issues 20 7. Realising your success 23 8. How Deloitte’s Corporate Finance team can help 24 9. The jargon – explained 26 Making the break –A practical guide to MBOs 1. Introduction During 1979, 18 management buy-outs (MBOs) took place in the UK, with a total value of £14m. In 2003 there were over 680 MBO transactions recorded with a market value of £16.1bn. Buy-outs are no longer a rare occurrence – they are now one of the most popular forms of acquisition in the UK economy. In the current economic climate buyouts at the robust end of M&A activity. As such, both the sources of finance available to buy-out teams and the complexity and range of possible financial structures have increased. An opportunity for an MBO is usually a once in a lifetime situation. Unfortunately, there are still a number of misconceptions that stop many managers even attempting an MBO. These include the following: Buy-outs are no • You have to be a millionaire to buy a business This is not the case. longer a rare A whole industry of venture capitalists and specialist bank departments exists to help occurrence – they management teams buy their business. The point of teaming up with these financiers is that they will provide the bulk of the funds needed to buy the business. By contrast, are now one of the management usually invest a relatively modest amount for a disproportionately high ownership stake. most popular forms • Management buy-out teams cannot compete with trade buyers of acquisition in the Experience has shown that this is not true. UK economy. There are a number of reasons why an MBO offer may be more acceptable to the seller than a rival bid from a trade buyer. These can include factors such as management’s understanding of all aspects of the potential of the business (and any problems), their ability to act quickly, and the fact that MBOs are often more acceptable to the workforce. MBO teams can and do outbid trade buyers. • Financiers will only invest in exceptional managers This is not strictly true. Investors are generally looking for a balanced team of managers who work well together and cover the key areas of the business. Leadership is important, but a successful buy-out is a joint effort by the right team of managers. 1 Making the break –A practical guide to MBOs • Only a small number of industrial sectors are likely to be suitable for MBOs Not so. Every sector of commerce has produced management buy-outs in the past (see Table 1), and will continue to do so. Table 1 – Industrial Distribution of UK MBOs by value 2003 Food Drink Agriculture 2.8% Health Pharma 2.5% Retail, Wholesale 16.2% Finance 3.5% Transport, Comms 3% Support Services 11.3% Property, Construction 2.8% Paper, printing & IT, Telecoms 8.1% publishing 5.5% Leadership is Manufacturing, Eng 7.4% important, but a Leisure 36.6% successful buy-out is Source: CMBOR/Deloitte/Barclays Private Equity a joint effort by the • Management buy-outs are multi-million pound transactions that only involve large companies right team of This is probably the biggest misconception of all. The average deal size is now around £25 million. managers. The majority of buy-outs are of medium sized companies, divisions and subsidiaries. The very largest buy-outs involving hundreds of millions of pounds are the exception rather than the rule. • MBOs are risky Not necessarily so. A well-structured MBO will take account of possible shortfalls in performance and ensure that the business can still meet its debt-servicing obligations. If plans are achieved however, management can make very high returns (far in excess of the returns available to institutional investors). So, if you want to see whether a management buy-out is a possibility for you, read on. 2 Making the break –A practical guide to MBOs 2. What is a management buy-out? A definition Essentially, a management buy-out is the purchase of a business by its management, usually in co-operation with outside financiers. Buy-outs vary in size, scope and complexity but the key feature is that the managers acquire an equity interest in their business, sometimes a controlling stake, for a relatively modest personal investment. The existing owners normally sell most or usually all of their investment to the managers and their co-investors. Essentially, a What do the participants want from a buy-out? management It is worth remembering that all the parties enter into a buy-out because they expect to gain something from the process. buy-out is the Clearly the management team stand to gain independence and autonomy, a chance to purchase of a influence the future direction of the company and the prospect of a capital gain. The financiers too will expect to participate in this success. As a reward for sharing in the risk of business by its ownership of an unquoted business they will expect a return on their investment. This return will probably take the form of an annual income stream, and the capital gain on the value of management, their equity. usually in The annual income stream typically comprises interest or institutional loan stock. The capital return will normally be generated by the sale of the business (perhaps by trade sale, flotation co-operation with or secondary buy-out). This is commonly referred to as the “exit”. How do buy-outs arise? outside financiers. Management buy-outs first came to prominence in the UK during the late 1970s. In recent years buy-outs have become a common feature in the UK’s corporate market. 3 Making the break –A practical guide to MBOs The sources of buy-outs are many and varied. The sources in recent years are shown in Table 2. These are discussed in more detail below. Table 2 – Sources of MBOs 2003: number (%) Unknown 10.6% Family and private 26% Secondary buy-out 9.1% Receivership 10.3% Foreign Public to private 5.4% parent 7.7% Public buy-in 0.3% Privatisation 0.3% Local parent 30.3% Source: CMBOR/Deloitte/Barclays Private Equity •A division or subsidiary of a larger group which is, or will become a non-core activity The sources of In these circumstances management can become isolated from the parent company’s overall strategy and in consequence may not be receiving the full support of the buy-outs are many organisation. The parent company may wish to dispose of the subsidiary in order to realise funds to invest in those business areas that are core. and varied. • Distress sales Highly geared groups may be required to raise funds at short notice. They are often compelled to accept a forced sale of a business to raise those funds. Management may be the only potential purchasers able to meet a short time scale. • Unwanted acquisitions In many large corporate acquisitions a bundle of businesses are transferred. It is often the case that the purchaser is not really interested in all the businesses in the bundle, but has taken them all for simplicity. The managers in those ‘unwanted’ acquisitions may be well placed to buy their companies, not least because their new parent may have borrowed heavily to fund the larger acquisition and may also face constraints on management resources in attempting to integrate the businesses acquired. • Succession issues Often, in established family companies no obvious successor exists for the owner/managers planning to retire. In such circumstances the incumbent managers may be able to purchase the company from the retiring family members or, frequently, a suitable solution is a management buy-in, which will see the current management being strengthened with new managers from outside. 4 Making the break –A practical guide to MBOs • Receiverships In a receivership there is a tendency for managers to attempt a buy-out in order to simply preserve their jobs. This is never a sufficient reason to attempt a buy-out. Where the company or group has failed it must be clearly demonstrated that the underlying cause of failure can be redressed after the buy-out. Where a group of companies has gone into receivership it may well be possible to purchase one or more profitable subsidiaries. • Divergent shareholder aspirations Whatever the reason In privately owned companies with diverse shareholder groups it is possible for the aspirations of different shareholders to diverge over time and this may require a for believing that an reorganisation of the shareholders. Such a reorganisation can often include a buy-out of certain of the shareholders. opportunity exists, • Secondary buy-outs A subset of the buy-outs arising from divergent shareholder aspirations is the increasingly it is important to common secondary buy-out. Institutional investors and, in some instances, members of a previous management buy-out team, may be seeking an exit from their investment. In realise that not every such circumstances a re-organisation of shareholdings is possible in which non-equity holding managers become shareholders and existing equity investments held by managers company can be can be restructured to allow some of their locked-in gain to be realised.